Friday, December 28, 2012

A few days ago I wrote a post describing shorting multi-level marketing schemes as akin to the Battle of Stalingrad.

Little did I know that Bill Ackman was shorting well over a billion dollars in Herbalife stock. [If you need the figure you can back work it out from comments in this BBC interview.]

Ackman has publicly said his target for the stock is zero - and the size of his position (huge both with respect to the company and his fund) and the ferocity of his attack means that his only honourable out is the total collapse of Herbalife.

Moreover Ackman is a very wealthy man controlling funds considerably larger than Herbalife's resources. He has said he can't be bought off. The only way Herbalife is going to get rid of him is by totally defeating him.

This is the hedge-fund equivalent of Stalingrad. Someone is going to lose big. And the victor will be so bloodied that the word victory will sound hollow...

For a short-seller who is as risk-averse as me watching this is pure hedge-fund porn.

John

PS. I am utterly convinced by everything in Bill Ackman's presentation except the final conclusion - that Herbalife's stock will collapse. I took a long position on Christmas Eve. I suspect that Herbalife is so profitable and so powerful they will see Mr Ackman's attack off - and the easiest way to do that is to buy back stock (and make the stock go up). Mr Ackman has given them the incentive to return their huge (but tainted) profits to shareholders (and I plan to be a recipient shareholder).

PPS. Ten years ago Ackman's old fund (Gotham Partners) wrote a defence of a multilevel marketing scheme called Pre-Paid Legal Services. They were long (which turned out OK in the end). The PDF document was called: "A Recommendation for Pre-Paid Legal Services, Inc". If anyone has a copy of the original PDF I would appreciate it. These days the report is only remembered because Gotham wrote the bullish report and sold stock into the subsequent rise. Elliot Spitzer investigated (an investigation that went nowhere).

Very interesting trade idea. HLF is clearly going to zero in anywhere up to 10 years due to the nature of pyramid schemes but maybe Ackman is squeezed out long before that occurs. Being long to me seems a bit exposed to external factors (SEC investigation, class action suits, further journalist investigation).

Based solely on what I have read on this blog and seen on CNBC - morality aside, shorting a company that makes a healthy profit off less than sophisticated people seems like a highly dubious use of capital. (Whats next, cash for gold?)

I would also question the idea that any amount of financial press coverage will lead to said people rethinking their positions and thereby terminating the scheme / business.

How do you expect they'd fund share buy backs/dividends? From back of the envelope calculations, using the entire cash stash + 100% of the profits for the next couple of years doesn't look enough to down a motivated opponent.

Plus if the management are deluded enough, they may just try to win by trying to expand the pyramid's base exponentially, and there it seems they're pretty close to capacity.

And if the financial press coverage leaks to the demographic that the product is crap and cheaper on eBay or from competitors...

"What if FTC accepts it as a pyramid scheme and shuts it down? Then it may go to $0. What is this odd?"

So this is more of a binary option on/if FTC or other legal entities around the world shut HLF down?

Makes more sense to me, HLF without intervention can still grow a few years in my view.

What I didn't get from the presentation is why Ackman is shorting now (I know they are slowly running out of countries, social groups). What stays around 32 years can also stay around 35 or 40 before collapse. I didn't see a short-term breakdown in their numbers.

No need to back anything out from BBC. Ackman details his position in this Bloomberg TV interview and confirms he has more than $1 billion at risk: http://www.bloomberg.com/video/herbalife-a-pyramid-scheme-ackman-says-J4hp3likSUGdwf_QnEs0TQ.html

I agree that HLF is not going to zero unless closed down by regulators - and yes I know the growth comes from finite geographical expansion but Shaklee has been around since the 30's NSA repositioned product wise and and maybe new distributor profile wise to be Juiceplus. Amway is alive and kicking after many years of being called a scam. What Ak has overlooked is the cult like atmosphere - people being recruited into MLM are told not to listen to outsiders who "don't understand".

Some observations on MLM

1) They are selling a dream with a multifaceted pitch if the money is not the prime motivator, then maybe be your own boss/work from home is. Selling the dream is what causes product to move. 2)A tiny handful of people DO get good incomes from MLM because the payout is deliberately structured so that a tiny handful do - I call it Porsche's per X hundred Km2 needed to show it is achievable - Porsche drivers cover a lot of territory being visible as ones who succeeded - some maybe by some buying of merchandise to get there. 3) People who get to the top in MLM are high quality [or previously misallocated] people - one of the top UK distributors for NSA was called Shami Dillon. It was assumed he just got in early - in UK calling someone a Dillon implies they are thick - a former commercial banker who met Shami D. reported back that he might as well have been meeting with the CEO of any corporate he used to deal with.4)Company makes money out of distributors who miss qualification and don't get paid on partial volume - they get zero for that months efforts but the company gets more than all.5) A significant revenue generator is expensive non buyback Starter kits - also similar types of things such as motivational tapes, seminars etc are {the?} major revenue generators for high level distributors.

MLM can be sold positioned as a financial instrument with an asymetric payoff profile i.e risk is 10% buyback haircut, possible exponential upside.

Part 1/4Some disclaimers - I'm not native English speaker, I actually work in an MLM company, I'm long HLF and also long the company I work for. I spent 5 years in a public "classic" company, then joined this MLM company 3 years ago. I've had the pleasure to sit one time with one of our investors (hedge fund) as a "field" person and I realise how little is known outside about the MLM business, even to top-notch hedge fund managers. I agree on some points with Ackman and rather just provide alternative answers to his critique below. Needless to say, I'm convinced in the viability of HLF and that PE should rather be around 12-15 for a company with such momentum and low penetration in many of it's markets.

The fundamentalsIn an MLM company, only 1-8% of the distributors ever embark on the journey to try to build a sales business. It is a deep misconception to think that all these millions of distributors have bought " the starter kits". The once who do certainly take some stock risk, as any entrepreneur does. Not all people are suited for small entreprenurial ventures and trying MLM is anyhow a very low-risk way to find out. You need to be patient and tolerant with people, you need to be a good speaker and willing to learn about product news and handle a constant info flow from the company, and pass this on to your distributors. You have to be able to handle a basic CRM system where you monitor your sales org (provided by the company). You have to be very outgoing, not afraid of contacting strangers spontaneously. You do not need any accountancy or logistics knowledge. The failure stories you hear is a very small part of the business and it happens in all sectors where entrepreneurs makes the leap. Do you hear that other small startups go out of business? It happens all the time, to tens of thousands of Americans, every day. Further, HLF has 80% of it's business in US- do not judge it using domestic American eyes. It is an EM play

Pop n dropHlf made some mistakes in late nineties and early 00's, it was too aggresively selling the "dream" like Ackman describes. It messed up at least in former Sovyet union (CIS) where it did ruin the lives of easily duped desperate people who took out loans to buy large stock of HLF which they could not move. Hlf virtually pulled out. Since 4-5 years ago they are back and flourishing, having changed the way they invite new distributors, doing a much more rigorous "interview" initially. Still, their business is not big in CIS and most certainly have a good 10-20 years of double digit growth ahead. Our company has popped several markets, dropped, then come back. It is about execution. Hlf track record in US is impressive to the entire industry by the way.

Going into exotic EMThe beauty of direct selling is that it can easily move into new markets, initially needing some basic logistics support and product licenses/ certificates. It is a low-risk way to see if your products have a demand. Sometimes distributors themselves open new markets informally by shipping products themselves, it happens to our company a lot. In exotic countries, retail is underdeveloped. They do not have wal-mart. Hlf likely want to establish their brand as the key weightloss product brand in these exotic EM and likely doing it because their distributors already found demand there.. Anyhow, the revenue there is immaterial in terms of revenue impact for now. It is not desperation, it is an interest in exploring new frontiers. Kind of something Americans have in their blood?

Part 2/4Inflated revenuesIndeed, a bit weird to use the hypothetical retail price for topline sales in the p&l but it is clearly stated that product sales are the real revenue that HLF sees and it is from that number the sales commisions in the mlm model is based. The mlm compensation part is carefully mathematically designed and it is always a static cost in your p&l. Certainly some rewards cost can be elsewhere, it can be large conference trips, temporary additional motivation programs etc etc. We have lots of these, all cleared by big4 accountants (for decades too). We do not Illustrate this hypothetical revenue in our p&l though.

Overpriced productsI would agree that HLF products are very expensive and they are difficult to move. But the distributors in HLF only need to make 1-2 sales per month whereas in other MLM companies the distributor have to make 6-10 sales of cheaper products to achieve the same volume, it is easier but more time-consuming. HLF has found a spot in the market, a sweet spot, and perhaps it will not continue forever. They will find new products however to replace formula 1, don't hesitate about that.

Internal sellingI have no doubt that a large part, easily up to 30-40% of the products are sold to and used solely by the distributors' segment I called consumers. It is not unusual or strange or risky. Think of those internal sales as a product club where consumers can get affordable weightloss products. They get invited to info-meetings and get some pressure to loose weight. These "registered consumers" are not loosing out to anyone else, they never take a risk buying large stock and they do not earn any extra money. Very small % (~10%) of the distributors are in this for selling at retail price and earning money that way, because there are no big money in that and few people are good salesmen. Either you buy at good discount or you join the minority who tries to build a business, by finding loads of other consumers.

Bonus or business pointAckman got this technically correct in most aspects, I would add the obvious that bonus points can be gathered either by a large volume of distributors buying small amounts of products each month or few distributors buying large amounts. As a "business builder" you attract either"consumers" or "sellers" depending on your personal style. The goal for a business builder is to find new smart people who decide to take this entrepreneurial path in life, not additional consumers to be honest. But new distributors never come straight to business, they first try products and then learn more about the opportunities. It is like cold calling - one in 100 is the right person. It is very difficult to find such people and most business builders only find one or two such partners, if any.

Part 3/4Nutrition clubsGreat stuff, the rest of us are impressed by this! We all try to achieve similar. Think that Ackman shows funny pictures of non-fancy club sites? This is pure snobbish arrogance and shows that you are out of touch with how the struggling world look like. It is a spit in the face of people living on small means, doing what they can to get out of poverty, to start building a business from scratch. What about all dorm rooms and garage office stories? It is how it starts.

No above the line marketing spendAn MLM company does not have space in the P&L for marketing as it spends so much on commisions to it's distributors who in essence are paid to do the marketing mouth to mouth, via clubs or larger info-meetings.That HLF chooses to market it's brand on sports team and events seams reasonable, it is affordable, it hits a good target group. Other MLM companies have marketed many different products and is reconsidering going back to market their umbrella brand instead since the clutter is so heavy among separate product brands.

The 2BUSD brand noone heard ofI agree this concentration is risky but I also know the good margins and the strong demand in these products. They should keep it and indeed expand their product range.

Top weighted rewards among distributorsAckman gets this fairly right and trust me that all MLM companies constantly evaluate where the rewards and commissions should go to achieve max effect. But it is the same in all MLM companies and here comes an element which is difficult for outsiders to understand - these few thousand people in the top play an important role in managing another 100 000 or so people among the remaining 2 millions in HLF case. They hold inspirational or educational seminars and they chase people to meet sales quotas - just like any sales manager in any business have to. They have to maintain the total sales volume - if they loose a couple of consumers, they or their partners have to find new. There is no possibility for fat cats here, you have to monitor and maintain your business to get commission every month. I saw comments that MLM companies earn money when distributors miss their sales targets and then the company "keeps" the commission. This is not correct, this commission is just re-distributed to other, new, distributors according to the marketing plan. No-one has a free ride. You could write a book about the dynamics from these people and I can say that MLM is so much more complex than traditional FMCG.

Overpaid CEOHe had lots of options, the sales and profit grew unexpectedly and dramatically since he joined 7-8 years ago. He cashed in finally, what is the deal about this. The COO just put his life savings and has lost a fortune thanks to recent share price movement (2mi USD purchase at price around 42), I do not see many writing about that..

Part 4/4Exploiting people vulnerable to the dreamI agree with Ackman that MLM does not attract PhDs. It is not an intellectual or refined business. It is not an easy way to earn money, it requires a lot of repetetive boring work and a certain set of skills. For people with no capital and no college degree, it is still one of several possible ways to build a small sales business. And here is another perspective on MLM - as a version of micro finance, it can lift people out of poverty in the world and generate positive benefits to unfavoured minorities in societies. This is of course considered as BS by most intellectuals.

Low R&DAgree with Ackman that HLF better start researching more for future products, although this hlf could detail out in the upcoming cap markets day. Many other mlm companies also have small r&d costs in relation to the total cost base, it is just true that many products are "commodity level" but they are apparently good enough and are offered with good enough discount to interest millions of customers each month.

Products selling cheaply at eBayAgree, it is not good. We have distributors price-dumping like that too, in all markets and we try to explain it is a short-term tactics that lowers image and retail price tolerance. They do it to attract leads, of among 100, there may be a new business builder. It is called customer acquisition cost and is used by all companies in the world to build customer base.

Gretchen Morgenson at NYTimes wrote about it back in 2003 http://www.nytimes.com/2003/01/19/business/a-rescue-ploy-now-haunts-a-hedge-fund-that-had-it-all.html?pagewanted=all&src=pmShe may still have a copy

Binary FTC thing - I dont think Ackman necessarily needs intervention to win. MLM companies down spiral when the number of new recruits fails to make up for those quitting (see Blyth). Some interviews with Spanish language media might serve him well in the US. EM? The underlying product is underwhelming, not compelling but cults have been built on stupider things. These situations are difficult to win - if $0 is the definition of winning - precisely because they are irrational. They are impervious to rational arguments - even ones composed of 300+ slides (see WAVX, wavoids). But Ackman only needs to convince at the margin (new recruits < churn) to unravel the rest and the stock will limp on in single digits, management howling at the moon... The saga will be entertaining. Although I get the (long) trade and think activist short selling can be akin to a strip tease in the death row wing I would not want to be a hedge fund or other money manager explaining to clients my rationale for being long when or if this goes south.

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.